The Internet has opened up a whole new realm in advertising, with Google at the helm. Within this, search advertising has recently come under investigation from competition authorities. This column seeks to aid the understanding of this special market, its definition, its structure, and the role of its leader.

The European Commission’s investigation of Google is focusing a lot of attention on search advertising. Another interested party in this area is the academic community, particularly theoretical and empirical economic researchers (see for example Athey and Ellinson 2011). Understanding this special market, its definition (that is, its borders with other markets), its structure, and the role of its leader is crucial for antitrust analysis.

The main aspect of search is the pervasive role of network externalities. The more Internet users reach a search platform, the more effective is an advertising campaign on the same platform. Since Internet users often join the platform with a commercial purpose in mind and use it to find information on products, advertising can be tailored to them in a much more effective way than with other means. Moreover, continuous technological innovations open new ways for advertisers to be ever more effective. This generates a very limited substitutability between online and traditional advertising.

Are online and traditional advertising substitutes?

In spite of this, some researchers have advanced the hypothesis that some substitutability between online and traditional advertising could exist because they both serve broad advertising goals (see Ratliff and Rubinfield 2010). However, this neglects a key difference.

Traditional advertising is aimed at building general brand-awareness usually without a specific target audience;

From this perspective, traditional and online advertising are almost always complements rather than substitutes.1 As such, they should be considered as separate markets.

Empirical evidence on the subject is limited. Goldfarb and Tucker (2011) provided an interesting analysis of substitutability between search advertising and a very particular form of offline advertising, marketing through mail and email. They use data on prices paid by US personal injury lawyers in search advertising comparing American States where they can and they cannot directly contact potential clients by mail.

Advertising prices per click are 5%-7% higher when state regulations forbid this form of offline advertising, suggesting that online and offline advertising could be substitutes. However, this conclusion can also be criticised on multiple grounds.

First, it does not really apply to the substitutability between online and traditional offline advertising, but mainly between search advertising and a marginal part of online advertising which is email advertising.

Second, it is not clear how to evaluate such a small percentage change of prices in search advertising as a response to a huge change of the price of mail advertising, since forbidding snail-mail marketing is equivalent to a prohibitive increase of its price. The traditional test of market definition of a reaction to a small price increase would probably give raise to an insignificant change in price for search advertising, suggesting that the markets are indeed separate.

The market structure

Having defined search advertising as a reasonably separate market, we can move to analyse its structure.

Search advertising is aimed at direct demand fulfilment, as witnessed by the "text-only" composition and the payments on a cost per click basis. Moreover, platforms compete to conquer the largest number of visitors and charge advertisers for the clicks they receive.

All the search engine platforms choose a quantity of advertisements to be made available in a specific order for any search query. Given the space allocated to these sponsored links, an auction pins down the market clearing price for these advertisements. The highest bid for each keyword association wins, with the price given by the second highest bid. This tends to force bidders to reveal their true evaluation of the click, which allows the auctioneer to choose the profit maximising auction mechanism.

Contrary to what is usually claimed, these auctions do not necessarily add a competitive element, but allow a dominant firm to adopt complex forms of price discrimination aimed at excluding competitors in search advertising or at extracting all the bidders’ surplus. Moreover, the auction process is made more complex by the different places where the ad can appear on the search page, and remains largely obscure to advertisers and competitors. Finally, most platforms have recently introduced click-weighted auctions that weight bids according to secret algorithms to give priority to advertisements with a larger chance to be clicked on. This mechanism is aimed at increasing the effective willingness to pay.

Scale in search

The structure of the market for search advertising depends on a particular form of network externality which is quite different from the one emerging in other markets of the New Economy. This is due to two main reasons, related to technological issues and to “multi-homing”. Let us start from the first.

Network effects in search are combined with a form of learning by doing. Search engines find more relevant results for each query when there are more queries and the subsequent clicks of the users provide information on what are the most relevant websites associated with keywords. Through this feedback, users improve the algorithms that govern the search engine (with a larger impact on tail queries compared to common queries on which all search engines reach a relatively large feedback). Therefore, not only does more search generate more demand for advertising (standard network effects), but more search also generates the scale needed to improve the search technology and provide more relevant results and ads, which in turn generates more search.

This is a key difference compared to other markets with network externalities, as those of other software platforms. On one side, in traditional platforms the number of consumers determines the demand of application developers but does not affect the quality of the software platform for a given number of applications, on the other side in search platforms the number of visitors determines the demand of advertisers and also the (future) quality of the search engine. This combination of network effects and learning by doing induces initial increasing returns to scale in this market ("revenue per search" has a typical S shape in the size of the web visitors).

As a consequence, for a platform to enter the search advertising market (or increase its market share) it is crucial to rapidly gain scale and close the gap on the search queries. At the same time, for a leading platform to maintain its dominance it is crucial to protect the information gained through search and limit the scale of the rivals.

Any exclusivity agreement between the dominant firm and distributors to install only its search-related products and services or between the dominant firm and advertisers to rely only on its platform may jeopardise the hopes of the competitors to compete on merit. This may be the case of the exclusivity agreements on the Google toolbar or on the search default settings between Google and software vendors such as Adobe, hardware vendors such as Apple, or browser distributors such as Firefox, Safari, and Opera.

Moreover, scale requires that any search engine must be able to access all websites and "crawl" them to find new information. Clearly, if the dominant platform obtains a privileged access to some relevant websites and limits the access of competitors, competition is penalised. Such a strategy of raising rivals' costs may exclude some competitors (or accommodate market outcomes with high prices that are detrimental to advertisers). In this case, innovation by the followers is penalised too. This is what may have happened since the acquisition of YouTube by Google, the main website for video content, whose access for competing search engines does not appear to be as direct and immediate as for Google.

Multi-homing on both sides

The other reason for which network effects in search are different from those of other markets is that multi-homing on both sides (by web visitors and advertisers) can easily spread benefits between different providers. Of course, multi-homing by consumers is key to drive the accumulation of information needed to build scale for a minor search engine. The fact that search engines are free and "one click away" on the Internet plays a double role in this context. On one side, it allows consumers to easily try minor search engines to test their capabilities, which enhances their chances to take off. On the other side, multi-homing by consumers allows those who are experimenting a minor search engine to quickly return to the dominant one jeopardising the chances of the former to develop and protecting the advantage of the latter.

Equally important is multi-homing on the advertisers' side. Since advertisers are uniquely interested in the effectiveness of their spending, they have good reasons to diversify their investments between alternative platforms in such a way that the marginal returns are equalised. Multi-homing guarantees that different Internet users can be reached with different search engines, typically with a higher budget destined to the leading channel (currently Google AdWord) and a smaller budget shared across the others (as Yahoo! Panama). Moreover, data analysis can easily allow for a comparison of the return on investment in each channel to optimise spending. It is clear that multi-homing by advertisers would contribute to the development of scale and efficiency for minor search platforms. Notice that this is quite different from what emerges in some of the other software platforms where multi-homing on both sides is often not necessary (think of the market for videogames, where consumers choose a single platform, but multi-homing by game developers guarantees network effects for all the platforms).

As a consequence, any policy aimed at limiting multi-homing creates obstacles to network effects. This may be the case for the contracts with which Google prohibits advertisers from using competing platforms, and for the exclusive use by Google of the data on its clients which prevents them from performing data analysis to compare the return on investment of different advertising channels.

1 Analogously, Amazon may compete with traditional bookstores, but does not compete with traditional advertisers of books (whose services actually promote the business of Amazon rather than being substitutes for it).